Dont Fret over the Rupee depreciation

By Dhiraj Nayyar, Chief Economist at Vedanta

There is much fretting about the depreciation of the rupee vis-a-vs the dollar.It is commonplace to equate a strong curency with a strong economy.But that is not true, especially in an emerging economy.As long as there isnt too much volatility and sufficient foreign reserves a depreciation of the rupee is nothing to worry about.

It is important to note that the exchange rate is a price fundamentally determined by the forces of demand and supply.What has happened in the last several weeks is that the Us Federal Reserve has increased the interest rates in a bid to curb the unprecedented inflation in US.This has led to the flight of capital from emerging economies like India back to the US increasing the demand for dollars and the sell off of Indian rupee.

The RBI can sell off their existing dollar reserves inorder to stem off the fall in the rupee.Indeed it has done so,but in the end the quantum of money that trades in the financial markets dwarfs the reserves maintained by the RBI.So the central bank can only mitigate and not reverse the trend.In any case, it is a fallacy to equate a strong or apreciating exhange rate with a strong and prosperous economy.Perhaps the only countries that have prospered with a strong or overvalued exchange rate is the oil producing economies. But they have a peculiar economic structure.They export an epensive commodity which has a price inelastic demand and they need to import practically every other goods.Hence it makes sense for them to maintain a strong currency which makes exports expensive and imports cheap.

Every other country particularly emerging economies prosper when the exchange rate is relatively undervalued against major currencies giving them a competitive advantage for export of goods and services.Chinas entire growth strategy for the past 3 decades depended on a depreciated yuan.In India there has been an implicit preference for a strong currency.Part of the reason is political optics and part of the reason is also economic,India is hugely depndent on pil imports.It imports almost 90% of its oil demand. And a weak rupee makes this critical item more expensive in domestic markets.Since oil is the major input in every other economic activity, it impacts the general level of inflation and even growth.

India or atleast its policymakers would be much more comfortable about the level of rupee if they had energy self reliance.That is a worthwhile goal and requires a two pronged approach - a) Increasing the exploration and supply of oil/gas domestically ,b) Investing in the scaling up of renewable energy technologies.. A weaker would complement the other policis that the union government has put inplace to boost manufacturing in India.

It must also be noted that currently the rupee is not a global currency because there is no full capital account convertability.Again policymakers have been righly cautious about liberalisation which can also open the door to more volatility.However eventually as a major economy, India will open its capital account fully.
A stronger currency rarely lays the foundation for a strong economy. But the strong economy paves the way for a strong currency.